Riding Out the Storm

By Michael Greeley

Nov. 12, 2008 | The economic environment is terrible—full stop. The financial devastation we are suffering with the echo-boom of the credit crisis will be felt for many years. We are a nation at war, the stock market is volatile, and we have the political indecision that inevitably settles in before fall elections.

Despite this backdrop, many venture capitalists felt relatively isolated from the credit market woes until recently. The credit crisis is now causing a much broader deterioration in the economic fundamentals. The situation for VC’s is worsened by the overall lack of liquidity; there have effectively been no IPO’s in a year and M&A activity is characterized by fewer, smaller deals—the negotiating leverage has clearly shifted to the acquirer. Even more troubling, the follow-on financing market, which many VC-backed companies rely upon to support product development and commercialization activities, is equally challenged.

It is also true though that many successful and valuable companies were launched in times like these. Notwithstanding the broad paralysis that has set in, there are strategies for entrepreneurs to deploy that will attract start-up capital. But they must be mindful of the context in which they operate.

Capital EfficiencyIn October, the third quarter 2008 Silicon Valley Venture Capitalist Confidence Index was released, showing that VC sentiment has not been this low for many years—and it will likely continue to plunge. This has profound effects on the VC environment, as many firms will become inwardly focused on existing portfolio companies. In 2007 the broader U.S. venture industry raised over $30 billion; through the first half of 2008, the VC industry raised only $11 billion, and it will struggle to reach $20 billion by the end of this year. We are poised to see a dramatic repositioning of the VC industry.

The phrase of the times is “capital efficiency.” Expect to see smaller financings—that is, the amount of capital raised in any given round should decrease (it is approximately $8 million per round now) as investors look to fund to nearer-term milestones. This will put a greater emphasis on management teams to be obsessively focused on building only those products customers will pay for now. Do not over-engineer product offerings with features that are not essential, hire only those people you need to accomplish near-term objectives. There will be a premium on successful managers who can demonstrate decisiveness and resourcefulness. Boards are counseling management teams to husband cash aggressively. In fact, many companies are exploring what the impact on business models would be if they were not able to raise any additional capital and how quickly the companies could get to breakeven.

Many venture firms are now discovering that they are under-reserved—the capital they had set aside for subsequent financing rounds is inadequate. Typically for every $1 invested, upwards of $3 to $4 should be reserved for later rounds. Many firms operated with lower reserves in the belief that other investors could be easily found to drive the additional rounds at higher valuations.

Expect also to see the “rolling thunder” of company closures wash across the landscape over the next 18-24 months, as companies fail to raise additional capital. This has a number of obvious negative impacts—in addition to investor distraction with closing portfolio companies, this will make many investors leery of investing in unproven business models and first-time entrepreneurs.

In 2007, according to Venture Economics, $30.7 billion was invested in venture-backed companies; through the first six months of 2008, $14.3 billion had been invested. Industry observers expect the third and fourth quarters fall off dramatically. The capital scarcity could last for the next couple of years.

All this demands that management teams be very thoughtful about the set of milestones that must be achieved in the short to medium to long terms. These would encompass product, market, and team milestones. Good investors will take the time and care to develop a financing strategy that overlays that.

Great CEOs recognize that it is not how much one raises but how much one owns of the company. Building a strong investor syndicate that is aligned on the long-term objectives but mindful of the steps in between, while perhaps more time intensive up front, should see a company through this challenging period.

Michael Greeley is a general partner at Flybridge Capital Partners and Chairman of the New England Venture Capital Association. He can be reached at michael@flybridge.com.